Higher Yields Coming To A Screen Near You
What You Missed
Interest rate markets continue to be caught between two opposing forces. First, better than expected economic data – including retail sales, industrial production, and jobless claims – are keeping the threat of another Fed rate hike alive and setting a floor of sorts under yields that are already trading at multi-decade highs. Second, geo-political tumult in the Middle East is prodding investors, seeking safety, into Treasury bonds, serving as a drag on yield’s move higher (higher demand for Treasuries = higher prices = lower yields). Amid all the uncertainty, members of the Fed’s rate-setting committee implied publicly that another rate hike may not be needed, with the idea that with yields already trading at multi-decade highs, the bond market is probably doing the Fed’s rate hike work for it.
Amid the crosscurrents, the Fed will choose patience and keep rates steady at its next policy meeting on November 1st, given that growth is predicted to slow on the back of sky-high yields, financial conditions are tightening, and geopolitical tensions are increasing. Looking further out, it may be a closer call at the Fed’s December 13th meeting. We’ll see.
Curious where rates are headed through year’s end? Watch our Q4 Interest Rate Outlook livestream, recorded Thursday, October 5th. Click here or email email@example.com
Running the Numbers: Long-term Rates Rise to Fresh Multi-Decade Highs
The yield on the 10-year Treasury note exceeded the psychologically important 5% level this morning, rising just above it to 5.02%, reaching its highest point since August 2007. We suspect there is some room for long-term yields to hold near these levels – even rise a bit more from here – with short-term yields likely to see more of a sizable rise over time.
For the week:
2-year Treasury yield: down 1 basis points to 5.10%
5-year Treasury yield: up 18 basis points to 4.90%
10-year Treasury yield: up 17 basis points to 4.97%
30-year Treasury yield: up 28 basis points to 5.12%
1-month Term SOFR: down 2 basis points to 5.32%
Where will SOFR be a year from now? 3-month (CME) Term SOFR, a useful gauge of hedging costs due to its vast liquidity over its 1-month counterpart, fell two basis points to 5.38%. The implied yield on the 3-month SOFR futures contract 1-year forward (September ‘24), an estimate of where markets expect 3-month Term SOFR to be a year from now, fell two basis points week-over-week, to 4.90%, reflecting the growing view that longer-term yields may be substituting for and additional Fed rate hikes.
How much higher will SOFR rise? 1-month SOFR, via the SOFR futures markets, and the forward curve they project to the world, is expected to peak at 5.40% in January 2024, then decline consistently over the next year as the Fed eventually cuts interest rates in Q2 2024.
Will rate cap costs ever decline? Rate volatility, a key driver of the cost of option-based interest rate hedges like rate caps, leap higher last week to levels last seen in early October. Any sharp rise in rate volatility, like that seen over the last week, helps to drive rate cap costs higher. Until there are clear signs that the Fed is on a rate cutting tilt, rate cap costs won’t decline precipitously.
Elsewhere, equities were lower on the week amid higher bond yields and unease over the potential widening of the war between Israel and Hamas. The price of a barrel of West Texas Intermediate crude oil rose $2.60 to $87.84 as the US dollar and Gold both strengthened.
Fed Chair Powell Implies Rates are at or Near Their Peak
The Fed Chair repeated recent statements made by other Fed members that rates are at or close to their high in remarks made last week to the Economic Club of New York. According to Powell, the economy is “resilient,” outperforming the long-term trend and cooling more slowly than the Fed would like. He reiterated the need for the Fed to remain cautious amid the likelihood that some of the long and various lags of monetary policy on the economy have yet to fully play out.
Our take: The Fed continues to focus almost exclusively on battling inflation. While the summer saw a decline in inflation, the September data has proven less promising. Even though economic growth will likely slow, if it holds above-trend, it will hinder any further progress in the Fed’s inflation fight. We expect the Fed to look beyond the recent spate of strong economic data, keeping rates steady into 2024, as the jump in longer-dated Treasury yields – if sustained – substitutes for the need for more rate hikes. The fly in the Merlot? If renewed supply shocks – in the form of higher oil prices emanating from the escalating Israel-Hamas war and/or a general increase in goods and services prices – drive up inflation again, the Fed’s rate hike pause in November may prove temporary, with the Fed opting for one more hike late this year or early next, but to compensate, engage in more aggressive rate cuts later.
Rates Traders are Bailing Out of November Rate Hike Bets
In recent weeks, demand in short bets that would profit from a Fed rate hike on November 1 had caused a record amount of risk to build up in CME Group Inc.’s fed funds futures contract for November. The Fed establishes a target range for its fed funds rate, and the contract is used to bet on monthly average levels of that rate. On October 17, open interest – the quantity of contracts in which traders had positions -reached 771,500, or $32 million for every basis point increase in the contract’s price.
Over the course of last week, that number fell by 63,000, or over 8%, to a whopping 708,000, driven lower by comments by Fed officials, including Chair Powell.
Blowout Economic Data is Making the Fed’s Job Harder
Retail sales – a highly watched barometer of the always important US consumer’s appetite to spend, increased over twice as fast as expected in September, although it probably overstates how resilient consumers are.
Headline retail sales for September beat expectations at 0.7%, vs. an upwardly revised 0.8% in August. That was much stronger than the consensus (0.3%). Automobile sales drove the rise, with new car sales rising 4.2% in September after falling 4.4% in August. A minor boost came from gasoline sales, as prices increased 2.1%, seasonally adjusted. While the data adds up to a strong Q3 for retail sales, it is likely that the strength can be attributed to one-off events from the summer (Taylor Swift concert anyone?) that won’t be repeated. Add in the resumption of student loan payments this month, and we will likely have a slowdown on the retail front in Q4.
Elsewhere, September’s industrial production exceeded forecasts of flat output, up 0.3% month over month. Factory production month over month rose 0.4%, beating estimates, but contracted 0.8% year over year. While encouraging on the surface, a downward revision to August’s data is responsible for around half of the upside surprise in manufacturing.
Finally, initial jobless claims declined 13k to 198k for the week, an encouraging sign for the job market on the surface. The declines were spread across the country; the states with the biggest drops were Texas (-3.2k), New York (-1.9k), California (-1.6k), and New Jersey (-1.6k). While also encouraging, there’s a big pothole lurking right around the corner: the UAW strike, which is now in its sixth week. Auto manufacturing is declining, and this will have a knock-on effect on other industries that supply parts to the auto manufacturing process, leading to an eventual rise in unemployment claims.
Our take: All told, the seemingly positive data makes the Fed’s job harder, as it shows the US economy is performing better than expected but will likely slow amid an erosion in its sources of strength in the coming quarter. For the Fed, it means that it will opt for patience and optionality, abstaining from any change in monetary policy in November, choosing instead to look to December as the impact of its 525 basis points of sustained rate hikes play out.
What to Watch: Even Higher Yields are Around the Corner
The rise in longer-dated Treasury yields Is the most significant recent macroeconomic trend of late. The cause, according to the Fed, is the re-emergence of term premium, which is the extra yield investors demand to compensate them for holding longer term Treasury bonds amid a cacophony of risks. These high Treasury yields, if sustained, will serve as a lagging drag on the economy, and could serve as a substitute for upwards of 0.50% in additional Fed rate hikes, allowing the Fed to avoid hiking rates again in this cycle. We’ll all have to wait and see if higher Treasury yields stick around to really know if this scenario will come to pass, but for now, it seems that there’s no reason for yields to fall precipitously.
In the meantime, the billion-dollar question on the “one more hike” or “no more hikes” front is whether the job market and economic activity are performing better than than what the Fed projected in its most recent Summary of Economic Projections, as well as whether or not inflation continues to rise. The first answer to that question will come from this Thursday’s release of Q3 GDP data and from Friday’s release of “super-core” inflation data (PCE deflator). Should core inflation rise for a second month, the Fed could be more confident to hike one more time.
Elsewhere, higher interest rates continue to bite, businesses are cutting back on investment (durable goods orders, Thursday), the housing market is cooling off once more (pending home sales, also Thursday), and household spending looks increasingly unsustainable since it is outpacing income growth (personal expenditure and income, Friday). Looking ahead and feeling confident in their projections, we suspect the Fed will consider the strength of Q3 GDP and ultimately decide to end the current cycle of rate hikes.
Strategy Corner: Let’s Talk Interest Rate Swaps
We’ve seen a rise in bank loans for refinancing bridge debt of late. The large and regional banks offer floating rate loans and swaps to synthetically fix the rate. The borrower is paying the floating index plus the credit spread on the loan. The swap, a separate contract from the loan, obligates the borrower to pay a fixed rate and receive the floating index. Simple math, the pay floating and receive floating offset, and the result is the borrower ends up paying a fixed rate plus the credit spread.
Swaps are an ideal way to manage floating rate risk. A swap can be structured in ways that mitigate risk tailored to the spcific goals and objectives of the borrower.
Important points to consider before executing an interest rate swap:
1) The bank selling to swap to the borrower earns fee income by adding a spread over the market swap fixed rate. A swap is an obligation to exchange interest payment streams (pay fix – receive floating) which means there is risk of default. The bank’s spread is the fee it receives for underwriting the default risk.
2) Swap spreads almost never correlate to the risk a bank is assuming, and in some cases, the fee income can exceed double-digits. The bank records the swap fee income on day one, a huge bump to their fee income versus recognizing the fee income over the life of the swap.
3) Fee income is based upon the Present Value of a 1 basis point change in the swap fixed rate multiplied by the swap spread. Assume a $25mm, 10-year term/25-year amortizing swap. The market rate is 4.00%, PV01 = $18,230, and the bank spread is 0.25%. Bank fee income: 25 x $18,230 = $455,750. All-in fixed rate to the borrower is 4.00% + 0.25% + Credit Spread.
4) The bank is incented to have the borrower hedge as much of the loan amount as possible and for as long as possible. Bank swap presentations always include a “non-reliance” disclaimer clause and “strongly recommend” hiring an independent advisor, as the bank clearly states that it isn’t giving the borrower hedging advice, is acting in their own interest, and is not acting as the borrower’s fiduciary.
5) The swap contact between bank and borrower is called the ISDA Agreement, and is comprised of two parts: the ISDA Master and the ISDA Schedule. The ISDA Master is like the Webster’s dictionary and is standard stuff and never negotiated. The ISDA Schedule is highly customized to the specific borrower and swap, and is the document where the “devil is in the details”. If you’re a borrower, NEVER sign the ISDA Schedule without having an attorney or advisor review it first. A non-negotiated ISDA Schedule is always in favor of the bank.
6) Derivative Logic is an independent, expert hedge advisor that can guide you through the process and provide the education to execute a hedge knowing the proposed structure is suited for a borrower’s particular goals and objectives.
7) Many borrowers are concerned about introducing an independent derivative advisor to the team because they are worried the bank might push back or closing may be delayed. If a bank recommends the borrower not hire an attorney that should be a red flag and alarm bells should go off in a borrower’s head.
We have an excellent reputation amongst the banks because we don’t negotiate with a baseball bat. They know we are team players.
How can Derivative Logic help?
1) Propose hedging strategies based on the borrower’s goals and risk tolerances. Fixing all the debt for the entire term of the loan can often lead to adding, rather than reducing, interest rate risk. We have many stories to share about borrowers going at it alone and ending up with a costly, undesirable outcome.
2) Swap fee cost savings through effective hedging structures and working with the lender to reduce the swap spread.
There is more to the process and we can provide a proposal of our services and fee structure. Call us for more information on how we can help. We also offer an in-person or Video presentation of our Derivatives 101 seminar.